Market Memo: Battle of Little Bighorn—Republicans retreat to the grassy knoll
As the market congratulates itself for having ignored all the bearish procrastinations about gridlock in Washington and the risks of the fiscal cliff—and in the process carrying the S&P 500 to our year-end 2012 target of 1,450—we see major near-term risks ahead before the market averages can resume their climb into the all-time high territory we foresee by this time next year (See Nov. 28, 2012’s “Short-term bearish, long-term bullish"). A metaphor for how we see things unfolding in the next few months can be found in the classic victory of the Lakota Sioux, Cheyenne and other Plains tribes over a small, though well-armed, band of American cavalry led by Lt. Col. George Armstrong Custer in 1876.
For readers who may have forgotten the details, Custer and his band were lured into a trap by a small army of Sioux out on the plains of Wyoming. After suffering severe initial losses, Custer and his men, many with arrows in their backs and chests, retreated to a grassy knoll, shot their remaining horses to use as shields against the barrage of arrows and bullets flying through the air, and proceeded to fight to the last man rather than surrender and suffer an even worse torture and death. Not to over-dramatize things, but it seems to us that Congressional Republicans, having been bloodied badly in Round Two of the Fiscal Cliff Wars (if I can count August 2011’s debt-ceiling showdown as Round One), find themselves in a very similar place as poor Custer.
Consider this. January’s fiscal cliff “compromise” gave the Republicans ZERO spending cuts in Washington in exchange for a large tax increase on wealthier Americans and small businesses, many of whom living in high tax states in the Northeast and California will see their all-in marginal tax rates rise to near 50%. In agreeing to this key presidential goal of creating more equality of after-tax outcomes by reducing the income of wealthy Americans, the Republicans calculated appropriately that they had little choice, given that the alternative was a massive, economy-wide tax increase that would have raised taxes on everyone, including the all-important working middle class. So, with eyes glazed over like political prisoners in a Soviet gulag, they finally relented, and signed the document at the final hour. Markets and many in the media have cheered, and both think the President Obama and Vice President Joe Biden have discovered a way around legislative gridlock going forward. We think both may be misreading what just happened.
Nothing left to lose
Like Lt. Col. Custer, the House Republicans certainly found themselves lured into a trap from which there was probably not an escape. But now they know where they are. And they know that in the final battle to come, surrender is no longer an option. Their political base may forgive them for having signed Obama’s tax bill with no concessions on spending in order to spare the middle class, but it will not forgive them again for doing so again simply to spare a probably deserved credit rating downgrade on the U.S. government. Instead, they will fight to the last man and woman, insisting on significant cutbacks to entitlement programs and big government spending in exchange for allowing further near-term expansion in the size of the government through an increase in the debt ceiling. If they don’t achieve this, they are dead politically anyway, so they know they have no choice. The Republicans have shot their horses and gathered into a tight band up on their grassy knoll, Capitol Hill.
With President Obama flush from his latest victory, and in full campaign mode, we don’t see much hope that a reasonable compromise will be coming from his direction. Hence, our view that Round Three, coming to theatres near you this February, will prove a protracted battle, with one side at least dug in, with their backs to the wall, and having no choice but to fight or die. It may take some time for markets to realize this, but when they do, a sell-off is likely.
Staying neutral … for now
Our full year market forecast of 1,660 on the S&P assumes that in the ensuing crisis, a compromise is reached and significant spending cuts are achieved. That would pave the way for a growth acceleration in the second half of this year, and a perception among investors that long-term risks in the market continue to abate, and that a higher market multiple is fair. But with the Battle of Little Bighorn looming, we are keeping our PRISM stock-bond call on neutral for now.
As an historical footnote, another battle fought by the American military nearly 100 years later, the Battle of the Bulge, started with a similar disastrous Round One outcome, and also saw the American commander declare “Nuts!” to a motion to surrender. In that battle to the last man, the good guys won ….